Eight Questions: Michael Pettis, ‘The Great Rebalancing’

Opinion on the outlook for China’s economy is sharply divided. China bulls believe that, with reform, China has another decade or more of rapid growth ahead of it. The bears maintain that imbalances are so great that a sharp slowdown in the next few years is inevitable.

China Real Time caught up with Mr. Pettis and threatened to pay him a below-inflation return on his savings unless he answered our eight questions.

The starting point of your analysis is the relationship between savings, investment and trade. Why start there?

The relationship between the three are well understood in economics but the implications are sometimes counterintuitive and usually forgotten, I started with basic accounting identities to show that much of what we think we know about trade and capital flows violates these principles and so is wrong.

China has a high savings rate. Is that just conservative households, or is something else at play?

We tend mistakenly to think of national savings rates in terms of cultural stereotypes. Aside from demographics, which change slowly, however, there are three things that mainly determine a country’s savings rates:

Most important is the GDP share of household income – the higher it is, the lower the national savings rate tends to be. Second is the amount of income inequality, with more unequal societies generally saving more. Third is the willingness to finance consumption with credit, which is itself determined largely by perceived changes in household wealth.

Any policy or condition that affects one or more of these factors will have an automatic impact on the national savings rate, and through that, on its current account and the current account of the rest of the world.

In China, growth, especially in the past decade, was heavily subsidized by hidden transfers from the household sector in the form of an undervalued currency, low wage growth, and most importantly, low interest rates. While this spurred rapid GDP growth, it caused the household share of that growth to collapse. It is no coincidence that the national savings rate surged at the same time.

Germany did something broadly similar at the beginning of the century, when an agreement between labor, business and the government restrained wage growth in order to boost employment. Right after that, the German savings rate soared while the savings rates of peripheral Europe collapsed. Again, this wasn’t merely coincidence.

How does that impact the China–U.S. trade relationship?

In China, household income is an extraordinarily low share of GDP, so naturally its savings rate is extraordinarily high, higher even than its extremely high investment rate. Since savings and investment must balance globally, this has automatic implications for the relationship in the U.S. between savings and investment. The balance of payments, after all, must balance.

This was one of the causes of the financial crisis?

Yes. In fact, throughout modern history savings and trade imbalances have been at the heart of most global financial crises. When domestic distortions force up or down a country’s savings rate, the impact on the trade account is of course matched by an opposite impact on the capital account and the result is a distortion in national balance sheets. A financial crisis is always a balance sheet crisis.

China’s current account surplus has shrunk to about 2.6% of GDP in 2012, from 10.1% in 2007 — does that mean the problem has been solved?

No, because the current account surplus did not shrink as a consequence of reduced savings, which is what is urgently needed in China. It shrank as a consequence of a surge in investment. The Chinese savings rate actually increased during this time. China’s trade surplus, in other words, did not decline because the country suddenly rebalanced. It declined because the rest of the world went into crisis and external demand collapsed. China was forced to choose between a surge in unemployment and a surge in investment, and for better or worse it chose the latter. This is why the current account contracted.

China now has rising wages, rising real interest rates and a stronger yuan – do these address the underlying problem of China’s high savings rate?

Yes they do, although this combination was only effective in the first half of 2012. Since then it has been partially reversed. This is why growth slowed sharply in the first half of 2012, only to surge again after the formal and informal banking systems were allowed to expand so dramatically in response to the slower growth.

Do you spot a lesson for China in what happened to Brazil after its decade of rapid growth?

It is not so much a lesson as a warning. Brazil’s miracle growth of the 1960s and 1970s was sustainable at first, but over the years, as always happens in similar cases, it became increasingly depended on debt-financed mal-investment. The result of many years of debt growing faster than Brazil’s debt-servicing capacity was an unsustainable debt burden, which ultimately left the country with the “lost decade” of the 1980s.

This is a common story, by the way. It seems to have happened many times during the last 100 years. Every example that I can find of a country that sustained an investment-led growth miracle ended with a debt crisis, a lost decade of slow growth, or both.

You’re expecting China’s growth to average about 3% for the next decade? What’s your forecast for 2013 and 2014?

Yes, I expect average growth rates over the next decade to drop sharply as China either chooses, or is forced by debt, to rebalance, but the pace depends on how quickly Beijing is able to consolidate power and impose the reforms it knows it must. If the leadership is successful in doing so quickly, I expect growth to drop to around 7% in 2013 and 5-6% in 2014. If not, I expect growth of around 8% in 2013. Growth in 2014 will then depend on how shaky the banking system will have become.

This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at 1-800-843-0008 or visit www.djreprints.com.